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Stocks that trade below their fair market value are known as undervalued stocks. Undervalued stocks are typically a great purchasing opportunity because their value often increases quickly presenting investors with the ability to turn a profit. For this reason, undervalued stocks are usually considered a good investment for stock market traders.
What are Undervalued Stocks?
To reiterate, an undervalued stock is a stock that has a market price that is well below its fair value. This low market price is typically caused by either consensus estimates or a lack of investor confidence. Often times, financial analysts will either use a company’s growth rate or the price-to-earnings ratio to determine if a stock is priced below its fair value or undervalued.
The main idea behind investing in undervalued stocks, or value investing, is that the market occasionally misprices a stock. The cause of this misprice can be a number of things; however, the following are the most common:
- Results that do not meet expectations
- Market crashes or changes
- Negative news about a company or stock
- Cyclical changes
Regardless of the cause, a stock is potentially undervalued if the firm’s fundamentals and the financial analysts’ consensus estimates point toward a market price below its fair value.
It is important to note that not all investors see eye to eye on undervalued stocks. While one investor may determine a specific stock to be an undervalued stock, another investor may disagree and determine that the stock is not priced below its fair value. Even if both investors use the same methods and tools to determine the value of the stock, the final conclusion is still swayed by individual factors that vary from investor to investor.
What Happens to Undervalued Stocks?
It is possible for an undervalued stock to stay consistently undervalued for many years. When this happens, the stock is labeled a value trap and the investor will most likely try to exit the stock.
While it is possible for the stock to become a value trap, the most likely outcome is that the market will become aware of its undervalued stock. This will lead to more purchases from new investors which will drive the market price up. As the stock’s value increases, it will draw further attention from investors who might choose to invest for other reasons. Eventually, the market price of the stock will be equal to or greater than its fair value. Once this occurs, the investors who purchased the stock when it was undervalued may choose to sell the stock for a profit.
Another possibility for undervalued stock is a complete sale of the company to a competitor or a new business in the given industry. Acquisitions like this are purchased at a premium to the market price; however, investors will sometimes hold on to the stock in the hopes that the company’s shareholders will fight for a larger offer. If the shareholders push and win a better offer, the investors of the undervalued stock gain a larger profit than if they had accepted the original offer; however, regardless of the route the acquisition goes, a profit is gained.
How to Identify Undervalued Stock
When looking for undervalued stock, there are five key indicators that investors look for:
- A low price-to-earnings (P/E) ratio
- A lower price compared to other industry competitors
- A low price-to-earnings growth (PEG) ratio
- A high dividend yield
- A low market-to-book ratio
Although it is not always the best method, the price-to-earnings ratio is the most widely used method to determine a stock’s relative value. Every company has a price-to-earnings ratio that indicates the price of the stock in relation to its earnings or profit. To calculate the price-to-earnings ratio, you divide the current stock price by its yearly earnings. If the price-to-earnings ratio is high, then the stock is likely priced high compared to its earnings. A lower price-to-earnings ratio could be an indicator of an undervalued stock, but this is not a reliable method to be used on its own as there could be many reasons for a low price-to-earnings ratio.
A stock price that is lower than that of its industry competitors could be a sign of low performance. If financial analysts deem a stock as a poor investment, then it is possible that investors will heed their advice and exit the stock. Eventually, the repeated sell offs of the stock will cause the price to decrease so significantly that it will become undervalued. When using this method to identify an undervalued stock, you should be sure to compare the histories of the stock price over several years with other stock prices as well as with stock indexes.
A more accurate way to evaluate a company’s price-to-earnings is by using the price-to-earnings growth ratio. To do this, you take the price-to-earnings ratio and divide it by the earnings growth rate over the next five years. For example, say the price-to-earnings ratio is 10 with a projected growth rate of 20%. The price-to-earnings growth ratio would be .50. A ratio below 1 suggests that investors are valuing past performance above potential future performance. While this can be a sign of a worthwhile investment, it is important to remember that growth projections are not set in stone and are not always accurate.
Another financial aspect to look at is the company’s dividend yield. A dividend payment rate that exceeds industry competitors might be a sign of an undervalued stock. A company that does not show any signs of financial hardship and seems to have a solid projection for future dividends could be a good stock investment opportunity. Investors will be set to receive decent dividends and provided the company continues to send out good returns, the stock’s market price might also increase. When looking at dividend yields, you should always make sure that the dividend has been either consistent or climbing over at least five years.
Investors can also look at the price-to-book ratio when searching for undervalued stocks. This ratio allows investors to determine a company’s margin of safety. A company will usually have both tangible and intangible assets. The value of a stock does not always reflect all of a company’s assets. The price-to-book ratio helps the investor evaluate the company’s stocks’ current market price in relation to his book value. A company with a price-to-book ratio less than 1 is considered to have a sizable margin of safety and therefore, points toward a possible undervalued stock situation.
While there is no one metric or calculation that can guarantee that a stock is undervalued, when these combined metrics point toward a lower-than-fair market price, there’s a possibility that you have identified an undervalued stock.
Five Current Examples of Undervalued Stocks
As previously noted, a company that has an increase in earnings is typically a smart investment due to the promise of a steady profit return. Based on the calculations of a discounted cash flow calculator, the following companies have displayed a steady growth in their earnings per share over the last five years:
- IPG Photonics Corp.
- Alliance Data Systems Corp.
- Robert Half International Inc.
- PVH Corp.
- Unum Group.
All of these companies listed are undervalued companies that have demonstrated a steady earnings per share growth rate. Based on the proper calculations, IPG Photonics has an earnings per share growth of 19.30% per year while Alliance Data Systems has an earnings per share growth of 18.20% per year. Both are currently undervalued at $123 per share.
Robert Half International has an earnings per share growth of 10.30% per year and its stock is currently undervalued at $53.89 per share. PVH has an earnings per share growth of 30.60% per year, an undervalued stock price of $76 per share, and a 60% margin of safety. Lastly, Unum Group has an earning per share growth rate of 5.10% per year and its stock is listed at $25.42 per share, 14.38% below its fair market value.
Get Started Investing in Undervalued Stocks
Although there are many methods and tools that can be used to run the metrics and measurements needed in searching for undervalued stocks, none of them can offer you a guaranteed profit. To increase your chances of accurately identifying and gaining from an undervalued stock, take advantage of the experienced team at RagingBull.
At RagingBull, you’ll find helpful information that can guide you as you seek to identify undervalued stock and make a profit on your investments. Their site offers free resources for you to study as well as a personalized free training session with one of their expert investors.